Book Reviews

Book Review of Full of Bull: Do what Wall Street does, not what it says, to make money in the market

Book review of “Full of Bull: Do what Wall Street does, not what it says, to make money in the market” by Stephen T. McClellan.

This is an interesting book. I always like reading books written by equity research analysts with decades of experience. Stephen McClellan has 32 years of experience covering high-tech stocks, most of which was spent at Merrill Lynch and Salomon Brothers. He was also ranked on the Institutional Investor All-American Research Team for 19 years.

The book goes through some good points about how to interpret the Buy/Sell ratings of Wall Street analysts, given the problems and conflicts that analysts face when giving and changing those ratings. Understanding the incentives/disincentives of analysts’ actions helps to give a better appreciation of why it is what it is.

Other good points highlighted are the analysts’ order of priority when conveying their research, the analyst calendar to get ranked, the classification of different management types, and an often overlooked point that dividends account for more than 40% of the total return.

Overall it is a good book with good tidbits sprinkled throughout, it also emphasizes the evaluation of management in the stock selection.

Decoding Wall Street’s Ratings

  1. Analysts have strong disincentives against negative views. They will get clobbered by their institutional clients and their own management. In 4Q05, Zacks Investment Research showed that out of 4,500 stocks, 42% were Buy/Strong Buy, only 3% were Sell/Strong Sell. In 2001, Salomon Smith Barney had 1 Underperform and no Sells among 1,200 stocks it covered.
  2. What ratings mean
    1. When an opinion is lowered from the peak rating, it means “Sell”.
    2. The Street interprets Hold opinions negatively, so should you.
    3. A Neutral short-term view but a slightly more positive Accumulate long-term view means the analyst is hedging. This is a terrifically negative view.
    4. When the recommendation changes from Sell to Neutral/Hold, it can be a good buying opportunity if the analyst is monitoring for more positive evidence before upgrading it to a Buy.
    5. Opinion changes based on the stock hitting a published price target should be taken lightly.
    6. Deletion of stock coverage or glaring lack of coverage are red flags because it is a way analysts use to avoid a downgrade.
  3. Analysts are late and are copycats.
    1. Once the 4th or 5th Sell opinion is issued for a stock, it is probably ready to recover.
    2. Analysts have difficulty upgrading a depressed stock because it can take too long to move and it may not have a clear catalyst. Once the stock has appreciated, it is much easier to get the necessary committee approvals and get clients to accept. Hence upgrades are late and would have missed much of the stock rise.
    3. Buy opinions are momentum driven and rarely value oriented.
    4. It is tough to downgrade based on excessive valuation alone, without hard facts and events to justify a downgrade. By the time enough evidence like earnings shortfalls or a drop off in orders happens, it is too late and the stock price has already fallen.
    5. Analysts go overboard in promoting their buy/sell calls, leading to stocks overreacting in both directions.
  4. Time horizon
    1. Ratings are given with a quarterly investment time horizon (1 to 5 months max) to match how institutional portfolio managers are measured.
    2. The short timeframe and daily scrambling means analysts seldom see major shifts in the industry.
  5. Analysts’ order of priority in conveying their research
    1. Own sales force
    2. Own traders
    3. Returning phone calls from institutional sales
    4. Press
    5. Key institutional clients
    6. Individual investors
  6. Euphemisms used
    1. Stock market drops = correction / volatility / turbulence
    2. Bottoming out = stabilizing
  7. In an Institutional Investor survey in Fall 2007, buyside firms were asked to rank 12 factors they sought from sell-side analysts in order of priority. Stock selection was 10th. Sell-side analysts are bad at stock picking, but usually good at providing thorough, informative company and industry research.

History Lessons

  1. In mid-1800s, U.S. railroads were the growth stocks of that era. Right-of-ways as short as a few miles went public and were chased by investors. Almost all of them went bankrupt.
  2. In the roaring 1920s, automobile, telephone, aircraft manufacturers were the new technologies of the era. DJIA quadrupled in 6 years from 1923 to 1929. The Radio Corporation of America (RCA) had its stock price soaring from under $10 to $100 and back to below $10 in the 1930s. Irving Fisher from Yale in October 1929 just before the crash stated that “Stock prices have reached what looks like a permanently high plateau.”
  3. DJIA stagnated in a narrow range from 1966 to 1982 for 18 consecutive years.
  4. In 1980s, Japanese stocks saw P/E top 100x (e.g. textiles, shipping). Reasons given were understated earnings, cross shareholdings, and world economic leadership. Investors rewarded market share expansion rather than profit growth, real estate prices rocketed. NTT had a P/E of 200x before dropping 80%, and the overall market dropping more than 60%, in the early 1990s.
  5. The 1990s bubble rewarded market share gains, intriguing business plans, and revenues rather than profits. P/Es peaked at 46.5x on Dec 2001. S&P500 tripled in 5 years.
  6. NASDAQ dropped 78% over 2.5 years after March 2000.
  7. Historical 25 year norm for P/E is around 15x.
  8. Research in the 1970s had no conflicts and were funded by high fixed commissions of $0.80 per share. After 1 May 1975, fixed commissions collapsed and research needs to be supported by investment banking and trading revenues, and commissions from large institutional investors.

Analyst Calendar

  1. Main event: The Institutional Investor magazine’s All-Start Team poll results released each October.
  2. Jan – May: Period of research frenzy – brokerage investor conferences, executive road shows, meeting with institutional clients, marketing trips, industry studies, special research, phone calls to influential institutional clients.
  3. Apr – Jun: Analysts do flamboyant opinion upgrades to gather votes.
  4. Jun – Aug: After the polls are closed, there might be a flurry of catch-up downgrades in late June or in August. July is earnings reporting time so it is risky to lower an opinion just ahead of results.
  5. Aug: Vacation – rarely have corporate developments or breaking news.

Axioms from “The Coming Computer Industry Shakeout – Winners, Losers, and Survivors” (1984)

  1. It never rains bad news, it pours.
  2. The first drop in profits is never the last.
  3. When insiders sell, you should too.
  4. Beware of stock price fixation.
  5. The bigger their egos, the harder they fall.
  6. Turnarounds are usually too little, too late.
  7. If you read it in the morning paper, it’s too late.
  8. When management says things are bad, assume they are terrible.
  9. If you don’t understand a company’s business, management may not either, and the more likely a screw up will happen down the road.
  10. The new digs are a bad sign.

Selecting the Best Company to Invest In

  1. Business Factors (Qualitative)
    1. Find unique, focused companies leading a new or niche market
      • It should have a structural characteristic that allows robust, dependable profit generation.
      • Avoid the me too, second- or third-largest players unless there is something that makes them better.
    2. Look for specialized, simple businesses
      • When specialist companies outgrow their sector, it is better to find more original virgin areas to pursue than to become generalised.
      • If it addresses a broad market, you need far-reaching economies of scale to have the most sizable share.
    3. Prefer smaller companies over giants
      • Companies under $1 – $2bn in revenue can sustain growth and attract better employees.
    4. Prefer companies with thriving customers
      • Thriving customers provide a good tailwind, compared to headwinds given by customers on the verge of bankruptcy.
  2. Business Factors (Quantitative)
    1. Seek double-digit growth or robust cash generation
      • Ultimate indicator of steady expansion is revenue, not profit.
      • Expansion rates of over 25% cannot be maintained over an extended period.
      • If profits have expanded for years with little revenue growth, it shows maturity in the business (e.g. IBM).
      • Look for recurring revenue from long-term contracts, it allows for predictable growth.
      • Free cash flow should be highly positive.
    2. Pursue healthy, stable, or expanding profit margins
      • For margins, it is the pattern over the last 10 years that counts (through weak economic periods), not the absolute level.
      • Prefer profit margins at the higher end of the peer group norm, preferably double-digit before taxes.
    3. Insist on a robust balance sheet and quality finances
      • Debt to capitalization (debt + equity) ratio should be under 20%.
      • Accounts receivable turnover under 90 days, no unbilled revenue, no rising trend.
  3. Management Factors
    1. Look for all-around quality in executives, customers, board members, and partners
    2. Avoid arrogant, overconfident management.
    3. Avoid weird stock structures (e.g. dual class voting stocks), or sweetheart management arrangements.
    4. Firms sizeable enough to be publicly held stocks should be fairly decentralized. Concentrated top management does not have the ability to make all the choices. If centralized control appears smooth and effective, material problems can hit like a flash flood overnight.

Evaluating Management

  1. Listen to executives on conference calls. It is worth a thousand reports.
  2. On founders
    • The best founders/leaders are able to shift their company’s direction as the sector matures, set high standards of performance, listen to the customer, are aggressive and driven.
    • Don’t be fooled by a founder’s past success when he launches another start-up in a different area. The earlier success is a confluence of all the right things at the right time, it cannot be recreated.
    • Learn to recognise founders that cannot adapt, e.g. they pooh-pooh competitive warnings and refuse to change.
  3. Types of good management
    • No-nonsense drivers – Chief Operating Officers that are tough, organized, detailed, serious, hard-working, quick studies, decision makers, and run a tight ship.
    • Worrywarts – Highly competent, but downplay its sucesses, presents negative aspects, and gives conservative earnings predictions.
  4. Types of management to be wary about
    • Good ‘ole boys – Entertaining friendly management that dodge penetrating questions with humour.
    • Techy geeks – Executives that launch into complex tech talk and brag about their technology.
    • Turnaround artists – Impressive and eloquent, but typically only cut costs, do buybacks, and fail to revitalize the company.
    • Hypesters – Experts at sales and marketing, frequently hyping but without substance.
    • Perfect host – Chairman/CEO that is smooth, confident, seems to have things under control. Always a shock when business turns sour.
    • Opportunists – Little past history, gives high unsustainable growth forecasts, do high-profile actions that pushes the stock price up.
  5. Middle road management
    • Ostrich – Old-fashioned executives, conservative, stable, low-risk, dull, slow profit margins, slow growth. Stock will have low P/E multiple, and justifiably so.
  6. Undesirable executive demeanor
    1. Surrounded by yes-men
    2. Stock price fixation
    3. Doing too much, lacking focus.
    4. Trash talk on analysts and competing companies
    5. Messy private life.

Investment Strategies and Execution

  1. Overall strategy
    • Don’t lose money. Think “How much can you lose if you are wrong?”
    • Hold no more than 5-10 different stocks and choose familiar companies.
    • Hold stocks long-term. The best performance is with stocks that prove to be winners over 5-10 years.
  2. Execution
    • When you pull the trigger, don’t quibble over pennies per share and risk  your order not getting completed.
  3. Reacting to downgrades and news
    • The first Street downgrade on a stock is your best, if not only, chance to sell. Once most analysts are pessimistic, the stock can only go back up.
    • Avoid selling the day of a downgrade. Most of the damage already happened within 1 hour. There is invariably a bounce back the next day or within a week if you want to sell.
    • Don’t buy/sell in reaction of press/media information, the information has already impacted the stock price before it appeared in the media.
    • Executive briefings and analyst meetings usually send stocks lower because the stocks have already run up in anticipation of favourable comments.
    • The first bad news is never the last. A stock that has been sliced to a fraction almost always continues to descend.
  4. On-going maintenance
    • Keep an open mind, pay attention to contrary evidence.
    • Exchange ideas with associates in the business (e.g. users, suppliers, management, investors)
    • Read the WSJ, stay abreast of trends.
    • Listen in on the conference calls, pay attention to the management tone and discern whether they sound trustworthy.
  5. Protecting profits / minimizing losses
    • If you achieved a large gain (e.g. 3x), leave room on the downside for a stop loss order (e.g. 30% below current price) , don’t give up a huge profit.
    • Have 2 selling price levels in mind for stocks that are underwater and where the outlook justifies a sell. The 1st price should be above the current price that is reasonable, the 2nd is a fail-safe protection price below the current price.
    • If it’s a trade, eliminate the position within a limited timeframe regardless of whether the idea was a winner or a non-event.
  6. Where to look
    • Hedge fund positions are sources of credible investment ideas because they have a direct personal stake.
    • Prefer NYSE over NASDAQ stocks because of more rigorous listing requirements. No more than 10% should be devoted to aggressive, speculative equities.
    • Low P/E multiples reduce downside risk when bad news occur, and increase chance for P/E expansion.
    • Invest in themes and rising industry sectors that are still underinvested. It is not too late to invest in a sector that is already starting to accelerate, there is typically a long ramp.
    • Dividends contribute 41% of the total stock market return from 1926-2006 (4.4% of the 11% annual gain). There is a positive correlation between dividend payout ratio and earnings growth (management pays out higher dividends when they have confidence in future earnings growth). Dividends reduce excess cash so executives are more careful with the money.
  7. What to avoid
    • Turnarounds almost never work. A turnaround is a trading opportunity at best, is never a long-term investment.
    • IPOs tend to underperform the market. 6 months after IPO, the management lock-up period expires and they can sell their insider shares, adding pressure to the stock.
    • Technology stocks are almost always overpriced, they make lousy growth stocks.
    • Companies doing a monster acquisition to turn attention away from current lousy results to a rosy future (e.g. Daimler/Chrysler, HP/Compaq, AT&T/NCR, AOL/Time Warner, Quest/U.S. West).
    • Stock buybacks are no substitute for growth, market share, and the more real catalysts that propel a stock. Be wary.
  8. Others
    • There is a January effect. If the market return is up in January, then the average gain is 14.8% over the remaining 11 months, else the average return is 2.9%.

Takeaways for Individual Investors

  1. Make astute, early investment in smaller companies not already picked over by Wall Street.
  2. Invest and hold stocks for at least 2 or 3 years to improve performance.
Analysts are usually late and are copycats. Once the 4th or 5th Sell opinion is issued for a stock, it is probably ready to recover.


  1. Author’s website


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